SECTION 1256 CONTRACTS AND STRADDLES: A GUIDE TO TAX PLANNING AND RISK MANAGEMENT

By Matthew Weber, CPA, MAcc | Director - Tax

Investing and trading in the financial markets can be a complex endeavor, and it is essential to consider several factors, including tax implications. Section 1256 of the Internal Revenue Code (IRC) addresses the taxation of certain derivative contracts, commonly known as Section 1256 contracts. Additionally, straddles, which involve offsetting positions in different securities or contracts, can have unique tax consequences. In this article, we will explore Section 1256 contracts and straddles, their definitions, and the tax treatment associated with them.

Section 1256 Contracts

Section 1256 of the IRC defines specific types of derivative contracts that are subject to special tax rules. These contracts include regulated futures contracts, foreign currency contracts, non-equity options, and dealer equity options.

Let us delve into each of these contract types:

Regulated Futures Contracts 1

These are standardized contracts traded on exchanges, such as futures contracts on commodities, stock indices, and interest rates. Taxation of regulated futures contracts is straightforward, as they are markedto-market at the end of each tax year. This means that gains and losses are treated as if the contracts were sold and repurchased at fair market value on the last trading day of the year.

Foreign Currency Contracts 2

Currency contracts, commonly known as forex contracts, are also included under Section 1256. Similar to regulated futures contracts, gains and losses on foreign currency contracts are treated as if they were sold and repurchased at fair market value at the end of the tax year.